Discretionary Income vs. Disposable Income

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Dec 19, 2022
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    Discretionary Income vs. Disposable Income

    Understand Your Income Before You Spend

    Income is the amount of money you earn for providing work, or in exchange for providing a product or service. Income can be spent to fund day-to-day expenditures and investments. Common sources of income include wages or salaries, business revenue, commissions, and bonuses. You may also earn income from other sources, such as investment returns, pensions, rentals from your property, and stock option plans.

    The income earned from these sources can be further classified as disposable income and discretionary income. These terms are often used interchangeably, but they imply different forms of revenue. Discretionary income refers to money that is left over after paying living expenses and other obligations. Disposable income, on the other hand, describes the amount of income available for spending after taxes are paid. Both Discretionary Income and Disposable Income are two measures of personal income, but they differ in many aspects. You must understand them to estimate your spending and plan your investments wisely.

    What is Discretionary Income?

    The term discretionary income refers to how much money a person has available after considering taxes and essentials like food, clothing, shelter. It is what you can use for spending on your personal choices in life, such as travel or entertainment. 

    Discretionary income is calculated by taking a person's total gross or pre-tax income into consideration. Gross income is your total earnings before any tax deductions. It is a sum of revenue from all sources, including investment returns and non-cash items such as services or property. If you are a salaried individual, the gross income is the total salary before tax and deductions. Any additional sources of income such as dividends, capital gains, rent received, tips, etc. are also a part of your gross income.

    You can arrive at your discretionary income amount by subtracting all taxes from your gross salary. The result is discretionary spendable money. It represents the maximum amount of money that an individual can use for his choices in life, such as travel, entertainment, charity donations, etc.

    The calculation of discretionary income can be done using the following formula-

    Discretionary income = Gross pay - (Taxes + Spending necessities (i.e., debt repayments, housing costs))

    For example, suppose your income is INR 1,000,000 and you pay income tax at the rate of 30%. Other than that, you spend on transportation, rent, insurance, food, clothing, and other necessities throughout the year. Your total expense for the year is INR 350,000. Then your discretionary income is INR 350,000 which is equivalent to the amount left after subtracting taxes and necessities.

    Discretionary Income can be calculated using the following method-

    INR1,000,000 - (INR1,000,000* 0.30) - INR 350,000

    What is Disposable Income?  

    Disposable income refers to the amount left over after you pay taxes from your total annual earnings. It reflects on whether people have enough money in their pockets for purchasing necessities and luxuries alike. It is an important figure for economists and policy-makers, as it indicates the health of a country’s economy. The number represents an individual's available cash flow. In good times, the disposable income of individuals tends to grow because they get paid more while inflation stays low. But in case the unemployment rates rise then spending power or "disposable income" falls as salaries stagnate or dip.

    Disposable income is calculated on your taxable income. The amount leftover from your gross earnings after deductions such as gratuity, provident fund (PF), and insurance is known as taxable income. It includes your monthly income, dividends from stocks, or earnings from other sources. The remaining amount of money after tax deductions is known as net income. This is the amount available to budget your day-to-day expenditures and investments. However, this amount is not an accurate representation of your wealth.

    Disposable income is equal to the sum of personal and government transfer payments minus personal tax liabilities. It does not include corporate profits, equity in rental properties, equity in untaxed trust funds, or government subsidies or transfers.

    The calculation of disposable income can be done using the following formula-

    Disposable income = Taxable Income - Taxes

    For example, assume that you earned INR 150,000 during the last financial year and your tax bracket is 30%. This means that your disposable income will be INR 150,000 - (150,000*30%) = INR 105,000, where 30% is the tax rate.

    Differences Between Discretionary Income and Disposable Income

    Following are the key difference between discretionary income and disposable income is the

    Discretionary Income Vs Disposable Income

    Discretionary Income is the leftover amount from your disposable income after all your essential expenses and investments.Disposable Income is the leftover amount from your gross income after deductions and tax payments.
    Discretionary income is the amount you can spend on your wants.Disposable Income is your take-home pay to be spent on your needs, investments, and wants.
    You can use your discretionary income for your non-essential expenses like buying luxury items or going on a vacation.You can use your disposable income for all your essential and non-essential expenses.
    Discretionary income impacts the performance of luxury and lifestyle brands.Disposable income impacts the retail marketing approach of companies selling necessary products such as food, automobile, and appliances, etc. 
    Discretionary income is a portion of your disposable income.Disposable income is always greater than your discretionary income.
    Changes in discretionary income may change the time duration of fulfilling your wants.An increase or decrease in your disposable income leads to changes in your discretionary income.

    How You Can Allocate Your Funds Based on Your Disposable Income?

    It is advisable to plan all your investments around your disposable income. You might have heard about the 50/30/20 financial rule of thumb. It's a way to allocate your budget according to three categories: needs, wants, and financial goals. The idea is not to follow it as a law, but rather as a guideline. It is intended to give you an idea of how you should be spending money each month based on these different priorities. 

    The 50/30/20 rule was published by Sen. Elizabeth Warren in her book ‘All Your Worth: The Ultimate Lifetime Money Plan’. She explained the distribution of disposable income according to this rule along with her daughter Amelia Warren Tyagi. It says 50% of your income should be spent on ‘needs’ like food, rent, healthcare coverage, etc. 30% can be spent on ‘wants’ such as clothes, shoes, vacations, or any other high-value expenses. The remaining 20% must be invested to meet your financial goals. Investing smartly after properly identifying your routine expenses and financial goals gives you peace of mind. Proper diversification of funds helps in wealth accumulation for the future while you are able to enjoy your present.


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